Why Exxon Is Our Preferred Major

 ExxonMobil (XOM) sets itself apart from the other majors as a superior capital allocator and operator and has historically delivered higher returns on capital relative to peers. The firm's strong third-quarter results demonstrate the competitive advantages, underlying portfolio improvements, and financial performance that make it our preferred major. First, we have long pointed to Exxon’s downstream operations (refining and chemical) as a competitive advantage that sets it apart from peers. This advantage was on display during the quarter as increases in downstream earnings offset lower upstream earnings, resulting in higher firmwide earnings despite lower commodity prices. Second, despite the lower total upstream earnings, unit margins are improving as liquid volumes increase as a portion of the portfolio. Total production slipped 4.7% from the third quarter last year. However, this includes the loss of low margin volumes from the UAE due to the concession expiring. Excluding these volumes, production fell only 1.0%, with liquids growing 0.6% and gas production falling 2.9%.

Earnings per barrel remained flat at about $18/boe despite a $9/bbl slide in oil prices. The improved margins are even more apparent when measured over the first nine months of the year. Despite oil prices averaging $2/bbl less, earnings per barrel year to date were $21/boe compared with $18/boe over the same period last year thanks to portfolio high-grading and the addition of higher margin production. Finally, the company is free cash flow positive, as cash flow from operations and proceeds from asset sales exceeded capital spending and shareholder distributions through the first nine months of the year. We expect these trends to continue in the coming years as improving upstream margins, a strong downstream segment, and lower capital spending combine to grow free cash flow (excluding asset sales). Combined with an attractive valuation, Exxon continues to rate as one of our preferred plays among the major integrated group.

Competition Is a Notable Obstacle
While we believe Exxon has an advantage in the current environment, that does not necessarily mean production and reserve gains will come easily or cheaply. Exxon's need for projects of a certain size in order to contribute meaningfully to its production profile and justify investment leaves it with a diminishing set of opportunities. Also, investing exclusively in large projects exposes it to a variety of risks including overinvestment risk, execution risk, and budgetary risk.

Greater competition is becoming an issue as more operators vie to partner in large projects with national oil companies. To gain access, Exxon must not only demonstrate its value but may also have to agree to terms that are not as advantageous as in the past. More often, management is faced with a tough decision: Take less favorable terms on more projects, or focus on projects where its expertise is highly valued. A good example of the latter case is Exxon's recent deal with Rosneft to explore for oil in the Russian Arctic. If Exxon is able to exploit similar opportunities where it can add oil reserves with attractive terms thanks to its value proposition, then it can probably continue to deliver superior returns.

One way Exxon is tackling its growth/reserve replacement issues is by investing in projects like oil sands and LNG that produce at plateau production levels for longer than traditional projects and reduce its overall decline rates. Also, relatively little reinvestment is required after the large initial up-front capital, resulting in significant free cash flow generation after startup. Production for these projects will constitute more than half the 1 mmboe/d of new production capacity Exxon plans to add by 2017.

Our Fair Value Estimate Is $109 per Share
We are maintaining our fair value estimate of $109 following the release of third-quarter results. We expect Exxon to actually increase oil volumes at a greater rate than natural gas over our forecast period thanks to large project startups over the next five years. Our forecast is slightly below management's forecast to compensate for the potential negative effects of higher oil prices related to production-sharing contracts as well as the risk associated with larger projects.

We expect strong results from Exxon's U.S. downstream segment as wide crude differentials shift to the U.S. Gulf Coast, benefiting Exxon, which has 1.5 mmbbl/d of refining capacity in the region. Additionally, it should benefit from wide differentials and processing of 100% advantaged crude through its Mid-Continent U.S. and Canadian refiners (600 mb/d). International weakness will likely continue, however, especially in Europe, where Exxon operates 1.7 mmbbl/d of refining capacity. We anticipate chemical earnings to remain tied to economic activity though operations in the U.S. should benefit as well from increased cost-advantaged feedstock.

Sustainable Excess Returns Earn Exxon a Wide Moat
Exxon earns a wide moat by integrating a low-cost upstream and downstream business to capture economic rents along the oil and gas value chain. While its peers operate a similar business model with the same goal, they fail to do so as successfully, as evidenced in the lower margins and returns compared with Exxon. The superior returns Exxon generates from the integration of low-cost assets (an intangible asset that we consider to be part of its moat source) combined with a low cost of capital produces excess returns greater than peers'. Accordingly, we have greater confidence that Exxon can continue to deliver excess returns for longer, earning it a wide moat compared with a narrow moat for peers.

Exxon's upstream segment holds a low-cost position based on an evaluation of Exxon's oil- and gas-producing assets, using our E&P moat framework. Its reserve life of 16 years, finding and development, or F&D, costs of $20/boe, and cash operating margins of 70% all easily clear our hurdles to consider the assets low-cost. Exxon also continually delivers upstream segment margins and returns far superior to peers'. Exxon's upstream margins in 2012 were 31% compared with a peer average of 23%. Returns were 21% compared with 18% for peers. We think this is in part due to integration with the downstream segment.

Exxon's size and integration between refining and chemical manufacturing give it a low-cost position thanks to economies of scale and access to unique assets. During the past 10 years, Exxon's downstream averaged returns of 24%. Even in 2009, when the global refining and chemical markets buckled in the wake of the global recession, Exxon's downstream earned its cost of capital with returns of 10% while others did not.

The integration between refining and chemicals is an unequaled advantage. As a result, Exxon delivers wider margins and higher returns than peers' despite a similar business model designed to capture the rents involved in hydrocarbon production and processing, irrespective of commodity prices.

A Return to Disciplined Capital Allocation Following XTO Acquisition
Rex Tillerson became chairman and CEO in 2006 and served previously as president. He has spent his career with Exxon, beginning in 1975 as a production engineer. The acquisition of XTO Energy raised concerns that he may be straying from the returns-focused strategy that has made ExxonMobil great and is instead investing in growth for the sake of growth. ExxonMobil's subsequent performance has lent weight to this argument as gas volumes have grown while prices have fallen, resulting in declining returns. However, while the acquisition has proven to be ill-timed given the drop in natural gas prices, we think ultimately it can deliver returns that meet ExxonMobil's requirements as prices rise and it leverages XTO's knowledge to exploit unconventional plays globally. In addition, management has set out to improve Exxon's eroding margins and declining earnings per barrel. Although higher commodity prices will help, delivering improvement and lowering its cost structure will be the key element to Exxon keeping its top spot among peers with respect to returns on capital.

ExxonMobil's record of generating shareholder returns deserves an Exemplary stewardship rating, in our opinion. Despite the XTO acquisition, we think Tillerson is likely to continue a disciplined capital allocation strategy, given his previous statements. Recent efforts to exploit more lucrative Kurdistan reserves at the risk of losing pre-existing, but likely lower-returning, Iraqi contracts provides us some evidence to his focus on returns.